Are absolute return funds the answer to investor prayers?

Absolute Return funds are designed to provide a profitable return regardless of whether the market goes up or down. It sounds like the perfect solution for investors who don’t want to risk their money. But not quite.

Fund performance has not exactly lived up to the hype. The volatility of stock markets since the 2008 financial crisis led to a massive increase in interest in the absolute return sector. The place to be if you felt markets were jumping around.

But as Andrew Merricks, head of investments at Skerritts Wealth Management explains, the last time that there was a meaningful correction was in the January of 2016 and the majority of absolute return funds did not do what they promised on the tin.

“At the time, we were quite confident that the markets were due a tumble of some proportion and so we tried to defend our portfolios by going overweight absolute return funds.”

He adds: “It’s not making the mistakes that cost you; it’s failing to learn from them. One or two of the absolute return funds that we invested in were absolute rubbish in doing what we had hoped from them. Not only did they follow the market down; they failed to catch the bounce when it came. A harsh lesson was learned.”

All-weather funds

The concept of absolute return funds is that fund managers can make money from shorting the market – that is anticipating that stock or bond markets will fall. They can also go long – that is make money when markets rise.

The flexibility of the funds to mix ‘long’ and ‘short’ investing was one of the main reasons so many absolute returns funds were launched after the market crash of 2008. The problem with bandwagon jumping and new investment products is that that there is no track record to support the heavy marketing.

Martin Bamford, chartered financial planner with Informed Choice, agrees with Merricks that Absolute Return funds, so far at least, have not proved the answer to investors’ prayers.

“I’ve been a critic of this sector and of absolute return funds in general for a very long time. Since they became more popular in the UK, they have consistently failed to deliver on their stated aim.

“More recent periods of market volatility have exposed many of the funds in the Investment Association Targeted Absolute Return sector as unable to deliver on their stated objectives.”

Protection and performance

So why haven’t absolute return products provided decent protection and why such massive differential on performance from funds in the same sector?

Patrick Connolly, at IFA Chase de Vere, provides some insight. “Too many absolute return funds are highly correlated to stock markets, so when markets fall they lose value, not to the same degree but then they don’t capture all of the upside either.

“This does mean that the performance of absolute return funds can look good when stock markets are rising, but then these funds are unlikely to provide the protection needed when markets fall.”

With regards to comparisons between absolute return products, Connolly also warns investors to be mindful. “It is often difficult to directly compare Absolute Return funds as they can take hugely different approaches. Some use hedge fund strategies, others are focused on shares or bonds or adopt a multi asset approach.”

He adds: “It is therefore no surprise that their performance can differ hugely. Over the past year the top performing fund in the sector made a gain of 29% while the worst performer lost 9%.”

Bamford makes the point that average performance in the sector has at least improved somewhat in recent years, thanks in part to poorly performing funds leaving the sector. However, cost (performance fees are often steep) and consistency remain major issues issue.

Connolly agrees that high costs are difficult to justify. “Performance fees are often charged at 20% of outperformance for beating a notional and irrelevant benchmark. That benchmark might, for example, be LIBOR rates which are currently around 0.5% per annum. This isn’t much of a hurdle.”

Performance fees are often charged at 20% of outperformance for beating a notional and irrelevant benchmark.

Hefty charges

The argument that performance fees align the interests of fund managers and investors is a flimsy one. Their interests should already be aligned without the need for performance fees.

As Connolly explains: “If a fund manager is confident in their ability to out-perform and wants to apply performance fees, the fairest way is first to reduce the ongoing annual charge and second to introduce a meaningful performance hurdle. Fund managers don’t seem particularly keen to do this.”

The FP Argonaut Absolute Return fund has a 20% performance fee. It returned 40%, 14% and 12% in 2013 to 2015 respectively, no doubt generating some pretty decent performance fees. After these payouts, investors wouldn’t have been happy to see the fund fall by 26% in 2016.

Bamford does identify a potential benefit of Absolute Return funds for investors. “What we really need to challenge is investor behaviour, where they are likely to sell during periods of market volatility. If using an absolute return fund which achieves its stated aim allows this to happen, then the fund has served a positive role.”

As things stand though, there are too many Absolute Return funds that charge too much and deliver too little.

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